Lecture 4

Question 1

What is Efficient Market Hypothesis?

Answer 1

EMH: stock prices reflect all available information meaning that prices adjust instantaneously to new information (which is unpredictable). Hence, the only way to earn a high return is to bear a high level of risk.

Question 2

Please describe random walk and provide the formula

Answer 2

Question 3

Please outline the types of market efficiency

Answer 3

Weak-form (historical information): history of past prices, trading volume or short interest is reflected in prices. All investors would have learned how to exploit buy or sell signals =⇒ technical analysis is fruitless.

Semi-strong form (public information): in addition to prices, data on earnings, dividends, product line or patents are reflected in prices =⇒ fundamental
analysis is useless.

Strong form (private information): insider information is reflected in prices

Question 4

What guarantees market efficiency?

Answer 4

investor rationality: all investors are rational and they value assets rationally,

or

collective rationality: some investors may be prone to behavioural biases, hence in
aggregate their trades are random and cancel each other out without affecting the prices,

or

arbitrage: most investors make systematic mistakes, but there exist rational arbitrageurs in the market who eliminate any effects from trading by irrational investors on the prices.

Question 5

What is the main implication of EMH?

Answer 5

EMH implies that competition among investors who exploit their knowledge (obtained from information processing) drives prices to levels where expected returns are exactly commensurate with risk and no abnormal returns can be earned.

Question 6

How may technical and fundamental analysis be used under the EMH?

Answer 6

Technical: Search for recurrent and predictable patterns in stock prices. If prices respond slowly enough to new fundamental information, technicians make profits on identifying trends.

Example: Sell stocks whose prices hit the resistance level and buy stocks whose prices are close to support level. Both levels are determined by market psychology.

Fundamental: Find an intrinsic value of the company based on earnings and dividends prospects and buy (sell) stocks which are currently traded below (above) the intrinsic value. You will only make money if your (unique) estimate is better than everyone else’s.

Example: Book value (shareholder’s equity) is a popular proxy for intrinsic value of the firm.

Question 7

What are a few examples of violation of weak and semi-strong EMH forms?

Answer 7

Short-run Momentum and Long-term Reversal: Jegadeesh and Titman (1993) find that a portfolio of stocks which perform well over the past 12 months will continue to perform well next month. DeBondt and Thaler (1985) find that a portfolio of stocks which perform well over the past 60 months will perform poorly next month.

Fundamental Predictors: Basu (1977) finds that a portfolio of stocks with low
price-earnings ratio earns higher returns than high P/E portfolio. Banz (1985) finds
that stocks with lower market capitalization will outperform a portfolio of stocks with higher market cap (by 8.52% per year, BKM).